Two-time finalist for Gerald Loeb Award - this year for Forbes magazine work and in 2010 for online commentary and blogging. I am a C.P.A. and freelance journalist with credits in the Financial Times, Boston Review, American Banker, Columbia Journalism Review, Accountancy Age, Accountancy Magazine, Forbes, and others. I also blog at my own site, re: The Auditors, a specialized news site about the business of the Big 4 audit firms. I have been quoted in the New York Times, Wall Street Journal, Chicago Tribune, Crain's Chicago Business, Chicago Magazine, Chicago Sun-Times, Financial Times, Reuters, Forbes, Harvard Business Review, BusinessWeek, American Lawyer, California Lawyer, American Banker, Columbia Journalism Review, The Times of London, The Guardian, the Financial Chronicle (India) and others. To reach me email fmckenna2010@gmail.com.

4/23/2012 @ 8:33AM68,584 views

This story appears in the May 7 edition of Forbes magazine on page 150.

Zynga, Facebook and Groupon all use an independent auditor that is simultaneously inventing the rules for social media accounting.

Somewhere, Arthur Andersen is shuddering.

For 26 million digital farmers working their fields and crops on Zynga’s popular game FarmVille, obtaining a virtual tractor, seeder or harvester can be transformative. A make-believe tractor, for example, ­allows you to plow four plots at a time. It’s the kind of productivity that laptop-bound farmers dream of.

The problem is that earning enough FarmVille currency to afford heavy farm equipment takes time. But like other social gaming companies, Zynga allows users to speed up the process by converting real dollars from their credit card and PayPal accounts into the FarmVille currency used to buy virtual goods. A hot rod tractor, for example, costs 55 in Farm Cash, which translates into $10 in real U.S. money.

For Zynga, which also owns CityVille, Zynga Poker, Mafia Wars and Words With Friends, virtual tractor sales are big business. The fledgling San Francisco company likely sells millions of tractors each year (that compares with 190,000 real tractors sold in 2011 in the U.S. and Canada). Sales of virtual goods, from FarmVille hay to Mafia Wars assault rifles, accounted for nearly all of Zynga’s $1.1 billion in 2011 revenues—and 12% of revenue for Zynga’s distributor, Facebook.

Which makes it very helpful that both have the same friend in the ­accounting business: Ernst & Young, the public auditor for Zynga and Facebook.

Ernst & Young wrote the book on accounting for virtual goods, literally. The third-largest accounting firm ­behind PricewaterhouseCoopers and Deloitte, it leads its rivals in the technology and burgeoning social media space. Neither the Financial Accounting Standards Board nor the Securities & Exchange Commission has issued rules for the likes of livestock love potions and virtual harvesters, so an E&Y document (updated this past March) lays out three revenue-recognition models it deems consistent with Generally Accepted Accounting Principles.

Such publications are well worth E&Y’ s effort, since its “Strategic Growth Markets” consulting unit helps companies develop their financial systems, controls and accounting policies well before they are ready to come public. Which is potentially problematic. A firm that consults on byzantine accounting rules for unusual revenue streams and also offers “independent” auditing services for the same companies?

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I think this article raises some serious questions. The AICPA states: “It is impossible to enumerate all circumstances in which the appearance of independence might be questioned… a member should evaluate whether that circumstance would lead a reasonable person aware of all the relevant facts to conclude that there is an unacceptable threat to the member’s and the firm’s independence.”

Despite what other readers on this forum seem to believe, the litmus test should not be if the financial reports are unreliable. Rather, the focus should be if Ernst & Young’s independence has been compromised. If the firm’s independence has already been compromised, this will in all likelihood lead to unreliable financial reporting. That is the entire purpose of requiring independence.

If the requirement were just “reliable reporting”, that would be fine. Investors want reliable reporting. However, audits are done by Certified Public Accountants with a responsibility to the public.

Independence is required in _fact_ and in _appearance_ for CPAs performing attest services. This is about more than reliable reporting.

Reliable reporting is a goal and independent auditors are a means toward that end. Can you get reliable reporting other ways? Perhaps, but you still wouldn’t be operating legally as a public company in today’s compliance framework.

Concealing facts that might raise questions about independence _itself_ raises questions about indendence. If you’re concealing that sort of information, maybe you throw in the towel, because you’re already questioning your own independence in appearance. By definition you’ve failed the test “that would cause a reasonable and informed third party, having knowledge of all relevant information, including safeguards fn 2 applied, to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or a member of the attest engagement team had been compromised. “

Francine-E &Y is creative for their clients as you state above and they are the go to auditors, yet you write in another piece that they were asleep at Groupon? I have no dog in this fight, but are they creative or asleep? Can they be both?

I’m not sure I said EY was either creative or asleep but I will look again to see if that was somehow implied. With regard to Groupon, most of the opinions belong to Ketz and Catanach. One of the big differences between audits of Groupon and audits of Zynga and Facebook is that the Groupon audit is done out of Chicago and the Facebook and Zynga out of West Coast offices. I think Facebook learned from Zynga’s mistakes and presented an S-1 that did not have as many complaints as all the Zynga early attempts. But Groupon seems intransigent, trying to pull off greater and greater feats accounting sloppiness. Ernst & Young is pretty aggressive, in general, in courting startups and is very service-oriented when it comes to helping them get set up. Does that extend to setting up accounting policy, procedure, controls, and systems, for example? We don’t know. But in Zynga’s case, it sure looks like they had a huge influence. In Groupon’s case, I think that the long term relationship with the investors Lefkowsky and Keywell – who also use EY for their other companies – and the impact of the Groupon audit on the Chicago practice has overwhelmed any professional skepticism that engagement team may have had.

How the Arthur Anderson debacle seems to have been forgotten, or maybe conveniently overlooked. Auditor independence and ethical behaviour is fundamental when engaging in an IPO bound firm and the audit / consultancy divide must be clear and maintained. It seems to me that the article smacks of the toxic debt issues around complex valuation and debt packaging structures that bamboozled even the so called brightest of the banking and finance community during 2007 is possibly rearing its ugly head once more, investors beware! In terms of revenue recognition on virtual goods, why the complexity. I maybe wrong but dollar are dollars and the goods as far as I know cannot be handed back, so surely recognise revenue at the point of sale, or is that to simple?

I realize the subject is auditor independence. However, I believe that the accounting issues should be addressed as well.

Here are some issues that I have related to this accounting method:

(1) For a high-growth company, the major item that investors are concerned about is growth in revenue and growth in profits. The accouting method that best enables investors to determine the company’s growth rate is immediate recognition of the revenue upon the sale. (2) There is no need to defer revenues from tractor sales. I would suggest that these future costs are so neglible in relation to the sale that they should be ignored. Zynga and Facebook have already developed these games. If the sold product was one that had to be developed by Facebook and Zynga, then this accounting treatment might be appropriate. But it isn’t. (3) Any accounting method designed should limit the discretion of management as to when to recognize revenue.

Great article, Francine. As you may have seen, we (Monadnock Research) published our Big Four conflict risk ratios at the end of February. The aggregated Big Four audit to non-tax consulting ratio went from 1.61675 in fiscal 2010 to 1.47429 in 2011, a shift of -8.81% (or 1,424.5 basis points) toward conflict risk (more consulting as a percentage of non-tax audit). With the proportion of consulting revenues increasing so dramatically at the Big Four, conflict risk is a serious issue that has the attention of global regulators. European authorities, as you know, have even proposed to break-up the Big Four to address it. Ernst & Young had $6.308 billion in non-tax advisory, and an audit to non-audit consulting ratio of 1.674. That was the second most favorable of the group in terms of relative conflict risk. But as this piece points out, a lot of that risk is concentrated in a large number of small growing firms. This high-risk consulting work will likely also have a long liability tail for E&Y if it leads into audit work in future years. While the risks are real and obvious to anyone that cares to see it, this is highly profitable consulting work, compared to lower-margin audit work. It’s obvious why they will continue to passionately defend it, and why self-regulation could never work.